Fred Chambers dabbled in real estate. He owned a rental property with his wife that kicked off a loss, and was also a member of a Tennessee LLC that owned between 5-8 rental properties, depending on the year. Chambers was responsible for managing the LLC, and spent a considerable amount of time doing so. The LLC, like Chambers’ individually owned rental property, produced sizeable losses, 33% of which were allocated to Chambers.

On his tax return, Chambers deducted the losses from his rental activities and LLC interest in full, taking the position that he was a “real estate professional.”

As a reminder, Section 469 disallows passive activity losses for any taxable year except to the extent they offset passive income. Rental activities are generally treated as per se passive regardless of whether the taxpayer materially participates. There are, however, two exceptions:

(1) for real estate professionals under section 469(c)(7), and

(2) for passive activity losses up to $25,000 under section 469(i). This benefit is only available if the taxpayers’ AGI does not exceed $150,000. Since Chamber’s AGI did, it wasn’t an option for him.

If a taxpayer qualifies as a real estate professional, his rental activities are not per se passive, and the losses are deductible in full assuming the necessary aterial participation is established. In order to satisfy the definition of a real estate professional, however, the taxpayer must meet a two-part test that’s been the source of frequent litigation:

First, more than one-half of the personal services performed in trades or businesses by the taxpayer during the year must be performed in real property trades or businesses in which the taxpayer materially participates.

If that test is met, there is still a second hurdle that must be overcome; the taxpayer must perform more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

For obvious reasons, meeting the test is very difficult for a taxpayer who works full-time in a non-real estate field. The average full-time employee works approximately 2,000 hours per year. Applying simple math, a taxpayer would have to spend 2,001 hours on their real estate activities, for a total yearly output of 4,001 hours. Now, while many martyrs accountants that I know call 4,000 hours of work “March,” the court’s have generally been unwilling to believe that a taxpayer can crank out that much work in a year’s time.

Even if the taxpayer is employed only part-time, the burden remains to prove that they spend more time on their real estate activities than at their day job. Often lost in this requirement, however, is the fact that only hours spent on real estate activities in which the taxpayer materially participates qualify to be counted towards the total.

This presented an interesting issue in the case of Chambers, which may well be one of first impression for the Tax Court.

In hopes of proving that he spent more time on his real estate activities than on his job with the Navy, Chambers counted his hours spent on both his personally owned rental activity and his management activities for the LLC. One problem. Section 469(h) provides that “No interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates.” Translated in English, that means that since an LLC is by definition a limited partnership, Chambers was barred by the statute from being treated as having materially participated in the LLC, and thus his hours couldn’t count towards his “real estate” total.

In a victory for prospective real estate professionals everywhere, however, the Tax Court took a different view, its conclusion grounded in the court’s noteworthy 2009 decision in Garnett v. Commissioner[i], which held that an interest in an LLC wasn’t de facto passive.

In Garnett, the taxpayer was a member of an Iowa LLC. Under state law, an LLC member — unlike a limited partner — is not prohibited from participating in the partnership’s business. As a result, the LLC interest more closely resembled a general partner then a limited partner, and thus, if the partner could establish that he materially participated in the partnership under one of the numerous tests found in Section 469, he could overcome the presumption that his LLC interest was passive.

Applying this holding to Chambers, the Tax Court found that as in Garnett, Tennessee state law permitted Chambers to participate in the management of the LLC. Furthermore, because the LLC was “member managed,” Chambers was required to participate in management under the articles of organization.

Thus, the Tax Court concluded that because Chambers’ interest in the LLC was not de facto passive under the statute — and because Chambers established that he materially participated in the partnership — he was permitted to count the hours spent working on the LLC towards his total “real estate” hours for purposes of passing the numerical real estate professional tests.

Unfortunately, the story doesn’t have a happy ending, as Chambers — even with the LLC hours counted towards his total — came up woefully short of proving that he spent more time on real estate activities than in his full-time job with the Navy. Regardless, this is a very important case for purported real estate professionals who spent a good deal of their time managing real estate LLCs, as it establishes that they can overcome the statute’s treatment of those hours as passive.

The items in this blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation. A select group of Tax Professionals of WithumSmith+Brown write Double Taxation, and any opinions expressed or implied are not necessarily shared by anyone else at WithumSmith+Brown.

Email Subscription

Enter your email address to subscribe to this blog and receive notifications of new posts by email.

Authors

Our tax specialists have a comprehensive understanding of international, federal, state and local tax regulations. We work with you to ensure tax reporting obligations are met in an accurate and timely manner, and to minimize or defer the payment of taxes, thereby adding value to your company. Through the use of technology, we stay up-to-the-minute on tax law changes, and know how they affect your business. Through our affiliation with HLB International, we can also assist you in developing cost-effective tax strategies anywhere in the world.